ICG Commodity Update – September 2022
The ICG Commodity Update is our monthly published comment on the energy, industrial metals and precious metals market.
Europe (and the world) is in the midst of an energy crisis that could materially worsen over the coming months. Europe has aggressively increased LNG imports to help offset the loss of Russian imports. To date, these have been accommodated by higher U.S. exports and lower LNG deliveries to China. North American natural gas prices could move higher through the winter heating season, enhancing the cash flow bonanza many companies are already experiencing. The intensifying global energy crisis has led politicians to consider incremental tax on oil & gas industry profits. The EU has proposed taxing the “windfall” earnings of oil & gas companies to the tune of €25bn. Analysts believe the policy is misguided out of convenience, as rising industry income is already a massive windfall to most producing jurisdictions via progressive royalties and taxes. As a cyclical business the industry relies on commodity upcycles to support full cycle returns on capital. Over the last 3 downturns the sector has written off $800 billion due to economic headwinds. Meanwhile, industry returns on capital have averaged <5% over the last decade, hardly “in excess” as many politicians suggest. Windfall tax also overlooks the root of the energy supply problem: underinvestment. While higher investment today may do little to ease near-term constraints, the fiscal uncertainty of a special tax is bad news for investment in future supply. There is mounting evidence that fossil fuel abhorrence and related policy is having a negative impact on global energy supply, and division over oil & gas investment is likely to extend if not worsen the crisis. Recently several high profile voices weighed in, reinforcing the position on the themes of global underinvestment and the sector’s necessary role in decarbonization/transition. Fossil fuel divestment may prove to be a problematic investment strategy as it not only leaves returns on the table, but also skirts opportunities to influence transition plans and ignores the vital role of oil & gas companies in leading/funding transition. The industry is already hesitant to invest, even though it generates record high cash flows. The weighted average free cash flow yield of the ECF portfolio companies increased to a record of over 24% this year. In other news, OPEC+ is preparing to meet this week to discuss the biggest production cut since the pandemic. The group is considering slashing production by more than 1 million barrels a day to revive plunging prices.
Commodity prices came under more pressure last month, as a deteriorating economic outlook and a surging US dollar weigh on the value of the world’s raw materials. The price of copper has fallen by nearly a third since March. Some of the largest miners are warning that in just a couple of years’ time, a massive shortfall will emerge for the world’s most critical metal. The recent downturn and the under-investment that ensues only threatens to make it worse, not only for copper but for base metals in general. Analysts say, the market is just reflecting the immediate concerns. But if people thought about the future, the world is changing. It’s going to be electrified, and it’s going to need a lot of metals. The latest price volatility means that new mine output, already projected to start petering out in 2024, could become even tighter in the near future. Last month, mining giant Newmont shelved plans for a $2 billion gold and copper project in Peru. Freeport, the world’s biggest publicly traded copper supplier, has warned that prices are now “insufficient” to support new investments. Commodities experts have been warning of a potential crunch for months, if not years. And the latest market downturn stands to exacerbate future supply problems by offering a false sense of security, choking off cash flow and chilling investments. It takes at least 10 years to develop a new mine and get it running, which means that the decisions producers are making today will help determine supplies for at least a decade. While much of the attention has been focused on lithium, the energy transition will be powered by a variety of raw materials, including nickel, cobalt and steel among others. When it comes to copper, millions of feet of copper wiring will be crucial to strengthening the world’s power grids, and tons upon tons will be needed to build wind and solar farms. EVs use more than twice as much copper as ICE cars, according to the Copper Alliance. Bloomberg estimates that demand for copper will increase by more than 50% from 2022 to 2040. To put it in context, in human history, we have mined 700mt of copper. To meet renewable energy demands, we need to do it all over again — but in the next 22 years. That’s setting up a scenario where the world could see a historic deficit of as much as 10mt in 2035, according to the S&P Global research.
Gold equities continue to be impacted by competing macro themes that represent both headwinds and tailwinds. On one hand, heightened uncertainty, both geopolitical and economic, is generating investor interest. On the other hand, gold equities have not escaped the recent market volatility with decade high inflation and rate hikes. Some investors are turning to precious metals as a store of value. While on the operational side of the mines, the threat of margin compression due to cost inflation is growing, and investors have been concerned about capital cost inflation for companies building new mines or expanding existing operations. Analysts expect to see a continued trend of investors preferring capital returns over growth, a sentiment that is not aided by inflation, which is perceived to increase the risk associated with capital-heavy growth projects. However, the gold price remains conducive to strong free cash flow generation, as it is still above its historical average. The world’s top gold mining executives see cost pressures sticking around into next year – those gathering at the Denver Gold Forum recently shared a collective view that the current economic environment is unprecedented. Gold prices are under pressure and equities tied to the yellow metal have slumped. Rising costs are plaguing mining companies and their operations around the world. While there has been a cooling of fuel prices, other components key to mining, including explosives and reagents, haven’t come down yet thanks to persistent inflation. According to analysts, such an environment leaves room for mergers and consolidation, especially for miners with cash and a need to grow. The best risk mitigator for any mining company is liquidity – The portfolio of the precious metals champions fund is on one hand defensive thanks to its by-mix of physical gold but also because of the selection of low cost and low indebted companies which are still generating a lot of cash even in an inflationary environment. Currently, the weighted average cash margin of the portfolio is standing at close to 50%, with an AISC of only $ 726/oz and a negative net debt to equity (companies are debt free). Even with gold prices at $1’660/oz, these companies are generating a free cash flow yield of over 11% next year – as much as never before.